What are bonds?
A bond is like an IOU for money that is, essentially, loaned by an investor to the bond's issuer, such as a company or a municipality.
In return for the use of that money, the issuer agrees to pay interest to the investor at a stated rate known as the coupon rate. At the end of an agreed-upon time period when the bond matures, the issuer repays the investor's principal.
Bonds may be sold by the issuer to individual investors, but are more generally purchased in large lots by firms that then resell to individuals and mutual fund companies. Investors are then free to buy and sell those bonds on the open market, which accounts for fluctuations in their price over time.
Because bonds tend not to move in tandem with stock investments, they help provide diversification in an investor's portfolio. They also help provide investors with an income stream, usually at a higher rate than money market investments.
All bonds carry some degree of credit risk, or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were expecting, and even some or all the principal amount invested.
Like stocks, all bonds can present the risk of price fluctuation (or market risk) to an investor who is unable to hold them until the maturity date (when the original principal amount is repaid to the bondholder). If an investor is forced to sell or liquidate a bond before it matures, and the bond's price has fallen, he or she can lose part of the principal investment as well as the future income stream.
Another risk common to all bonds is interest rate risk. In normal circumstances, when market interest rate levels rise, existing bonds' market values usually drop (and vice versa), although past performance does not assure future results. However, interest rate risk's effect on market value may be a relatively minor factor for income-oriented, buy-and-hold investment strategies. That's because bondholders are generally entitled to receive the full principal value of their bonds at maturity, regardless of any short-term changes in market value that might have been caused by fluctuations in market interest rates.
Saving and investing basics
Please consider the charges, risks, expenses and investment objectives carefully before purchasing a mutual fund or exchange-traded fund. For a prospectus containing this and other information, please contact a financial professional. Read it carefully before you invest or send money.